Nobody sets the price of coffee. No committee meets to decide it. Yet a price exists, it changes, and it somehow rations a limited supply among everyone who wants some. Understanding how that happens without anyone arranging it is the single most useful thing economics teaches, and it starts with two curves.
Demand
The quantity of a good consumers are willing and able to buy at a given price over a given period.
Supply
The quantity of a good producers are willing and able to sell at a given price over a given period.
A single consumer's demand for a good is individual demand. Adding up the quantities demanded by every consumer at each price gives market demand, so the market demand curve is the sum of all the individual demand curves. Market supply is built in the same way from the supply of every firm. A movement along a demand curve caused by a change in the good's own price is called an extension of demand when quantity demanded rises and a contraction when it falls; the same words are used for supply.
The demand curve slopes downward because as price falls, buyers who were previously priced out enter the market, and existing buyers find the good more attractive relative to substitutes. The supply curve slopes upward because higher prices make production more profitable, so firms devote more resources to that good and higher-cost producers find it worth entering.
The phrase 'willing and able' is doing real work and examiners look for it. Wanting a car is not demand. Wanting a car and having the money to buy one is. Candidates who write only 'how much people want to buy' rarely secure the second mark.
Economists call demand backed by the ability to pay effective demand, and at AS it is the only kind that counts. Notional demand, the wish to buy without the means, has no effect on price because it never reaches the market. The distinction matters when income changes: a rise in income turns some notional demand into effective demand, which is why demand curves shift right when incomes rise.
Shifts versus movements
This distinction separates strong answers from weak ones, and it comes down to a single question: what changed? If the price of the good itself changed, you move along the existing curve, and that is called a change in quantity demanded or quantity supplied. If anything else changed, the whole curve shifts, and that is called a change in demand or supply. Income, tastes, the price of substitutes and complements, and population all shift demand. Production costs, technology, taxes, subsidies, weather and the number of firms all shift supply.
Each cause of a shift works for a reason worth stating. Demand shifts right when incomes rise, for normal goods, because buyers can afford more at every price; for inferior goods, such as the cheapest own-brand foods, it shifts left, as buyers switch to better alternatives. A rise in the price of a substitute shifts demand right, and a rise in the price of a complement shifts it left. Advertising and changes in fashion or tastes shift demand in the direction the change favours. A larger population, or a change in its age structure, changes how many buyers there are for particular goods. Expectations matter too: if buyers expect prices to rise next month they buy more now.
Supply shifts for the same kind of reasons on the producer's side. A rise in the cost of raw materials, wages or energy makes each unit dearer to produce, so supply shifts left. Better technology lowers costs and shifts supply right. An indirect tax is like an extra cost and shifts supply left; a subsidy works the other way. More firms entering the market shift supply right. Weather and disease shift the supply of farm goods, sometimes sharply. And goods produced together, such as beef and leather, are in joint supply, so a rise in the output of one raises the supply of the other.
The most common diagram error in this topic is shifting a curve when the question describes a price change caused by the other curve moving. If the price of coffee rises because a frost destroyed the harvest, supply shifts left and you move along the demand curve. Demand itself does not shift. Ask yourself what caused the price change before you draw anything.
The government raises income tax, reducing household disposable income. What happens in the market for restaurant meals, a normal good?
Show the effect on the market for wheat of a government subsidy paid to farmers.
Supply shifts right. Mark both the original and new equilibrium, label the axes, and show the direction of change in price and quantity.
Equilibrium price
The price at which quantity demanded equals quantity supplied, so there is no tendency to change.
Away from equilibrium the market corrects itself. Above the equilibrium price, supply exceeds demand and the resulting surplus pushes sellers to cut prices. Below it, demand exceeds supply and the shortage lets sellers raise prices. Neither adjustment requires anyone to plan it, which is the central insight of the price mechanism.
Finding equilibrium and disequilibrium from a schedule
The weekly market for a snack is shown below. Price $1.00: quantity demanded 900, quantity supplied 300. Price $1.50: quantity demanded 700, quantity supplied 500. Price $2.00: quantity demanded 600, quantity supplied 600. Price $2.50: quantity demanded 500, quantity supplied 700. Find the equilibrium, then describe the market at $1.50 and at $2.50.
The functions of price
At AS Level you are expected to explain not just how price is determined but what it does. Price performs three jobs at once. It rations, by allocating a limited quantity to those willing to pay most. It signals, by transmitting information about relative scarcity to producers and consumers who have no other way of knowing what others want. And it incentivises, by rewarding firms that move resources into markets where prices have risen. A rising price is simultaneously a rationing device, a message and a reward.
How a market absorbs a supply shock
- A poor harvest reduces the quantity producers can supply at every price, shifting supply left.
- At the original price, quantity demanded now exceeds quantity supplied, creating a shortage.
- Unsatisfied buyers bid against one another, so price rises.
- The higher price rations the reduced supply, since buyers who value the good least withdraw first, and this is a movement along the demand curve.
- The higher price simultaneously signals scarcity to producers elsewhere.
- It also incentivises them, since production is now more profitable, so resources are drawn into the market.
- A new equilibrium is reached at a higher price and lower quantity, and in the longer run the entry of new supply moderates the price rise.
Notice the chain names all three functions of price as it runs. Weaving the theory through the mechanism, rather than listing it separately, is what earns the analysis marks.
Practise this chain →Markets are also linked to one another. Complements are in joint demand, so a fall in the price of one raises demand for the other. Substitutes are in alternative demand, so a fall in the price of one reduces demand for the other. Derived demand arises where a good is wanted not for itself but for what it helps produce, as with steel and cars, or labour and the output it makes. Joint supply occurs where producing one good automatically produces another, as with beef and leather.
Consumer and producer surplus
Consumer surplus is the gap between what buyers would have been willing to pay and what they actually paid, shown as the area under the demand curve and above the market price. Producer surplus is the gap between the price producers receive and the minimum they would have accepted, shown as the area above the supply curve and below the price. Together they measure the total gain from the market existing at all, which is why economists use them to judge whether an intervention has made society better or worse off.
Draw a market in equilibrium and shade consumer surplus and producer surplus. Then shift demand right and show how each area changes.
Both areas grow, but by how much depends on the elasticity of supply. Say which assumption you are making about the slope of the supply curve.
Surplus questions are almost always really about elasticity. How much surplus changes when price moves depends on how steep the curves are. If you are asked to analyse the effect of a shift on consumer surplus, state the elasticity assumption you are making and your answer immediately gains depth.
Applied context
Ride-hailing surge pricing is the price mechanism operating in real time and in public view. When demand spikes after a concert, the algorithm raises fares, which rations the available cars to those who value the journey most and simultaneously signals to drivers elsewhere in the city that it is worth heading over. Supply responds within minutes. It is also the clearest illustration of why the mechanism is politically contentious: efficient rationing by willingness to pay looks a great deal like profiteering to the person paying four times the usual fare.
This example lets you make the efficiency case and the equity objection from a single illustration, which is exactly what an evaluation question rewards.
How far can the demand and supply model be trusted?
- The model assumes buyers and sellers have good information and act rationally. Behavioural evidence shows both assumptions fail regularly.
- It assumes prices adjust quickly. In practice wages and many contract prices are sticky, so shortages and surpluses can persist for long periods.
- Rationing by price allocates to those with the most money, not the greatest need, which is an equity objection rather than an efficiency one.
- The analysis holds other markets constant, yet in reality a shift in one market moves prices in linked markets simultaneously.
- The speed and size of adjustment depend on elasticity, so any conclusion about the magnitude of a price change should state the elasticity assumption behind it.